The timing of the stock market meltdown on Aug. 24 was uncanny, at least in the eyes of the exchange-traded product ecosystem.
Just a week before, comments streamed into the Securities and Exchange Commission from asset managers, trading firms, analysts, and other ETP market participants and observers.
They were responding to a June 2015 request for comment that focused significantly on the role of market makers, exchanges and broker-dealers in supporting ETP trading and information.
Now, some observers are calling for separate consideration for ETPs during times of extreme market stress, as few of the questions and even fewer responses anticipated the events of the morning of Aug. 24.
That day, volatile overseas trading pushed S&P 500 index futures to a trading halt before the equity market open. In turn, the NYSE invoked its Rule 48, which allows designated market makers to step away from making their mandatory opening indications. As NYSE stocks and ETPs opened, waves of selling pushed prices to trigger limit-down circuit breakers and subsequent trading halts, implemented after the May 6, 2010, “flash crash.”
According to Credit Suisse Trading Strategy's Ana Avramovic, 27 ETFs that regularly trade more than 500,000 shares per day experienced trading halts, as well as 300 more with less daily volume. Combined with 128 stocks, 43 of which trade more than 500,000 shares per day, there were 1,258 trading halts.
This cocktail of slow-to-open or frequently halted stocks and a one-sided market amid a liquidity squeeze resulted in unusual behavior for some ETPs. Without enough information to effectively price a two-sided market, many ETP market makers widened their quotes significantly and significantly decreased the size of bids and offers to adjust for volatility and risk. Some stepped away altogether.
The trading halts and absence of market makers on opening/reopening of trading resulted in many ETP trades executed at what some believe were unreasonable prices.
Trades “happened in an orderly, logical fashion (just at stupid prices),” wrote Dave Nadig on FactSet Insight. Mr. Nadig is director of exchange-traded funds at FactSet. There are still “real issues” in the current market structure, he concluded.
An anonymous commenter to the SEC, who had filed a detailed, and sometimes scathing, 100-plus-page critique of the ETF market on Aug. 17, called this action “the ETF stress test” in a follow-on letter.
The commenter references vastly different pricing and trading for two ETFs tied to the S&P 500. At their lowest executed trades during the open, the SPDR S&P 500 ETF priced the index at 1,829 and the iShares S&P 500 ETF priced the index at 1,480.
Many other large and liquid domestic ETFs traded at prices more than 10% down from the Aug. 21 close, including 12 with more than $1 billion in assets experiencing temporary price drops between 15% and 51% that morning.
ETF market makers generally price bids and offers based on their calculations of fair value. But, when so many securities in an ETF's creation/redemption basket are halted, a market maker's ability to arbitrage price discrepancies between the ETF price and the fair value of the underlying securities is disrupted. As a result, trading models widen the quote spread to take advantage of this uncertainty while keeping the market maker protected.
FactSet's Mr. Nadig analyzed specific trades for the Guggenheim Equal Weight S&P 500 ETF and found most of the trades at the open and following trading halts were odd lots below 100 shares and many were single shares.
With market makers largely out of the trading, high-frequency trading algorithms were left to trade with themselves, while “sleeping stops,” stop-loss orders that become market orders through the stop, were triggered.
“Transparency and clarity were taken out of the ETF dynamic, and traders priced in that uncertainty,” wrote Anita Rausch, director of capital markets for WisdomTree Investments. “The markets experienced something new and remarkable ... but within the (first) hour it learned, recovered and returned” to order.
Ben Johnson, director of ETF research at Morningstar Inc. in Chicago, wonders if the ETP market itself actually needs a separate set of rules. “It takes a village to foster an ETF,” he said, adding that a cross-jurisdictional, multiregulator working group is required to bring about investor-friendly rules for ETPs.
SEC Chairwoman “Mary Jo White has brought a very data-driven approach to her regulatory process,” said Valerie Bogard, equity market analyst at TABB Group in New York. “I have no doubt that the SEC will look at the public comments as well as the data from that day to see what changes need to be made.” n